What’s Wrong With Domestic Oil Investing?

Published on by on November 30, 2009

Although oil prices remain far below all time highs, crude has seen a significant run-up in prices over the last several months. But unlike previous periods of rapid oil price appreciation, shares of domestic energy companies have been held in check this time around, moving sideways despite a theoretically more favorable environment.

The breakdown of this historically strong relationship has left investors in domestic energy ETFs confused and frustrated. In searching for an explanation, one theory looks at tactics that have been used in the past in similar environments, wondering if perhaps a repeat is possible. In 1979, as oil prices quickly doubled and the Carter administration faced a massive deficit, a windfall profits tax was implemented on domestic oil companies, essentially reallocating earnings from the energy sector to the government.

There has been no windfall profits tax in the U.S. since 1988, but there are also several reasons why the coming months could see a reintroduction. At least seven bills purporting to tax windfall profits of crude oil producers were introduced in Congress in 2008, and president Obama has made it clear that he would sign such a bill. “I’ll make oil companies like Exxon pay a tax on their windfall profits, and we’ll use the money to help families pay for their skyrocketing energy costs and other bills,” said Obama while campaigning in North Carolina in 2008.

Compared to the price run-up in oil prices of 2006 and 2007, the recent rise in the cost of crude has been moderate, and public outrage is far from the fever pitch it reached a few years ago. But if gas prices hit $4 per gallon at the pump, don’t be surprised if that changes overnight.

ETF Alternatives

Investors expecting oil prices to rise have historically utilized domestic oil stocks (and more recently, domestic energy ETFs) as a proxy to play this trend. But with the threat of government intervention looming, the relationship between these funds and oil prices may be significantly weakened.

There are several ETF options for investors looking to gain exposure to the global industry while minimizing investments in U.S. companies:

  • Dow Jones Emerging Markets Energy Titans Index Fund (EEO): This ETF invests in companies operating in the oil and gas producers, oil equipment and services, and alternative energy sectors in emerging markets. EEO’s holdings include stocks listed in India (Reliance Industries), Russia (Gazprom and Lukoil), Brazil (Petroleo Brasileiro), and China (PetroChina), as well as South Africa, Thailand, Chile, Colombia, Poland, and Hungary.
  • iShares S&P Global Energy Index Fund (IXC): This ETF is designed to track the performance of the global energy sector, including companies in both developed and emerging markets. While this ETF has exposure to about 15 different countries, nearly half of its assets are allocated to the U.S., leaving it open to the same problems potentially facing “pure play” U.S. energy funds such as XLE.

For a more in-depth look at the developing situation, see What’s Wrong With Domestic Oil Investing? written by Richard Kang, chief investment officer and director of research at Emerging Global Advisors.